Market Summary & Analysis

Market Summary and Analysis is provided by Larry McMillan. Mr. McMillan is the President of McMillan Analysis Corporation.

Volatility trending higher
Moving higher again this month, CBOE Volatility Index (VIX) Futures established an uptrend which is typically a bearish sign for stocks. On Friday, May 18th, VIX closed at 25.10, up substantially from the recent low in late April near 16. The rise in VIX has accompanied a general decline in the stock market, as measured by the Standard & Poor's 500 Index (SPX) and other major indices. The decline in SPX has been rather orderly and steady, which has not lead to a corresponding increase in realized volatility.

As a consequence, there has been a large discrepancy between realized (historical, actual, statistical) and implied volatility (VIX). The 20-day historical volatility of SPX stands at about 12% after Friday's trading. VIX neared 25, causing a 13-point differential between implied and historical volatility. Such large differences are rare, but not unheard of. They usually point to a period of increased actual volatility in the stock market. Hence, if the past is any guide, we would expect to see a much more volatile stock market in the coming weeks and months.

The VIX settlement value rose to 21.46 this month, from the multi-year low of 14.55 in April. Figure 1 shows the entire history of the monthly VIX settlement prices, since the inception of futures trading in May 2004 (trading first began in March, 2004, and the first contracts that settled were the May, 2004, futures). The symbol for the monthly settlement price is VRO. The SPX is also overlaid on the graph. While there is not a perfect (inverse) correlation between SPX and VRO (and, by inference, VIX), one can see the general tendency of the two to move in opposite directions.

Figure 1 Source: McMillan Analysis Corp

VIX has spent a considerable time in the 17 to 21 trading range this year. If VIX drops below 17 that is a typical sign that it has been bullish for stocks, as was the case in the last half of March. But when VIX is above that range, it is a typical sign that it is bearish for stocks, which is what we are seeing now. If VIX were to fall back below 21, stocks would likely stop trending lower, although SPX is still likely to be quite volatile on a day-to-day basis.

Premium and Term StructureTable 1 shows the VIX futures term structure on May 18th. There has been a substantial change over the last few days. First of all, the term structure has flattened. Notice how closely together the prices of the futures are in the first four or five months. A great deal of this flattening happened on May 17th and 18th, as VIX futures prices rose greater than the rise in VIX itself. The greatest rise was in the near-term futures.

The term structure still slopes upward in later months, but the differential between front month (June) futures and the longest-term (January 2013) futures is only 1.95 now. In recent months, it had been as wide as 7.

Another interesting fact can be gleaned from the data in Table 1 and that is the premium in the front month is at 3.10, once again very large. June futures became the front month last Wednesday making this a sizeable premium with just a relatively short time remaining until expiration.

The VIX future is still somewhat bullish in that the futures are trading at premiums to VIX and the term structure slopes upward. However, if the term structure were to invert and start to slope downward, that would likely be negative for the stock market.

StrategyWhen the front month VIX futures have large premium the hedged strategy could be the best one, taking both a short position in VIX futures as well as in the stock market. Professional traders, who take larger risks, prefer other ways of doing essentially the same thing: Selling both VIX futures, while buying SPX or SPY calls as a hedge. In both cases the ratio of VIX to SPY or SPX is not one-to-one. Rather one must account for the differential in price and volatility in order to produce a neutral position.

For example, if one were going to use the first approach, VIX put options and SPY put options – then the calculation would be as follows:

So the above formula calculates the ratio as 0.905, or about one-to-one for smaller positions. That is, buy one VIX June at-the-money put for each SPY June at-the-money put.

At most times, the formula requires more VIX than SPY, but the extremely low historical volatility of SPY distorts the current figure slightly. In fact, a 4 VIX to 3 SPY ratio might be more historically correct, even though the formula is not exactly calling for that at this moment.

In either case, the trade would be held until the June VIX futures premium substantially shrinks.

VIX Futures in Focus

VIX Futures in Focus is provided by Michael McCarty. Mr. McCarty is the founding member and chief strategist of Differential Research.

Inter Market Volatility Arbitrage III

As volumes continue to grow in CBOE Volatility Index (VIX) futures (VX) as well as in the recently launched volatility index security futures, we continue to look at the relative relationships to better define, quantify and ultimately attempt to capitalize on inter-market volatility arbitrage opportunities.

Sources: CFE, Differential Research, LLC

May marked the first expiration for the CBOE Crude Oil ETF Volatility Index security futures contract (OVSM), which is based on the United States Oil Fund, LP (USO) Exchange-Traded Fund (ETF) and designed to provide a tradable instrument representing market expectations for 30-day volatility of the USO. The May OV settled at $32.13. The May CBOE Emerging Markets ETF Volatility Index security futures contract (VXEMSM) settled at $33.75 and the May CBOE Brazil ETF Volatility Index security futures contract (VXEWSM) settled at $37.99. The May VX Future settled at $21.46 while the CBOE Gold ETF Volatility Index security futures contract (GVSM) settled at $21.46.

Sources: CFE, Differential Research, LLC

ETF based Volatility Index security futures continued to garner the greatest interest as shown in the chart above.

Sources: CFE, Differential Research, LLC

Volume and open interest in the VX future peaked as it ascended to the front serial position.

Sources: CFE, Differential Research, LLC

Sources: CFE, Differential Research, LLC

With the data remaining limited, initial patterns based upon the small sample set may be disproved as markets develop and mature and volumes grow. However for now, volatility markets visually remain highly correlated.

Sources: CFE, Differential Research, LLC

One important consideration for anyone establishing an arbitrage position in the different volatility index futures and security futures is contract size. For VX futures the multiplier is $1,000 while the multiplier for volatility index security futures is $100.

On May 23, 2012 the CBOE Nasdaq-100 Volatility Index Futures (VNSM) contracts began trading on CFE. VN futures have a multiplier of $1,000, and reflect implied volatility expectations derived by applying the VIX methodology to options on the NASDAQ-100 Index (NDX).

Volatility Futures: Relative Strength - A Family of Futures Products

Many investors are familiar with the CBOE Volatility Index (VIX) that is calculated based on options on the S&P 500 Index option and is an indicator of implied volatility and investor sentiment. But some may not be aware that CBOE Futures ExchangeSM (CFE) lists and trades the VIX futures contract (Ticker symbol: VX).

The popularity of the VX futures contract has grown and the VX futures contract recently experienced its highest trading volume month in March 2012 with 1.96 million contracts traded, which is an 84% increase from a year earlier.i

As the popularity of the VX futures contract increases, CFE continues to expand the volatility index franchise to include futures and security futures contracts covering several underlying markets. See the table below for a list of the volatility index futures and security futures that CFE currently offers for trading on its market.

From the retail investor to the institutional investor or money manager such as a Commodity Trading Advisor or hedge fund, there is always the question: "How can an investor utilize these contracts in a portfolio?"

There are three components to this answer: 1) The contracts traded on CFE have standard trading hours, trade on a quality exchange, offer price discovery, provide marked-to-market transparency, provide liquidity, have margins and are subject to regulations. 2) The contracts traded on CFE futures may be utilized relative to the underlying market to increase or decrease volatility exposure. 3) The contracts traded on CFE may be utilized relative to the other CFE contracts, in essence creating a spread among the different CFE products.

An example of relative strength would be that the VX futures contract tends to move higher when the S&P 500 Index is selling (the negative volatility increases). The correlation of the VIX to the SP is -0.87.ii

Holding long positions in VX futures could offer both potential tail risk protection and a potential reduction of correlation risk. An investor could also play the VX future on the short side, if they believe the underlying market will rally.

On this same theme, if an investor analyzes volatility of the Brazilian equity market, they could employ the CBOE Brazil ETF Volatility Index Security Futures contract (VXEW). The calculation of the VXEW is derived from the VIX methodology applied to options on the iShares MSCI Brazil Index fund (EWZ) listed on Chicago Board Options Exchange, Incorporated (CBOE). These options were ranked the 17th most actively traded exchanged-traded fund (ETF) options in the U.S. in 2011 as noted CBOE.iii One should keep in mind the growing demand for Brazilian investments as Brazil is the "B" of the "BRIC" emerging market economies.

If an investor believes the Brazilian equity market may fall or the potential for tail risk and volatility may increase, then holding a long position in VXEW may offer a risk management technique with the potential reduction of volatility of the exposure of holding the Brazilian investment.

The VXEW may also offer potential reward as a directional play if the investor does not have exposure to the Brazilian market or they are seeking global macro strategies, for example in a managed futures portfolio or a hedge fund portfolio.

On a relative basis, an investor could also spread the VX futures contract against the VXEW security futures contract to seek an increase or decrease of relative strength between the two markets. Chart 1 below shows a 30-day historical volatility of the past 11 years for the iShares MSCI Brazilian index and the S&P 500 Index and for potential spreading opportunities.

Since the financial crisis, there appears to be an increased correlation of 30-day volatility between the U.S and Brazilian markets. The volatility of the S&P 500 tends to remain in the lower range of the Brazilian volatility.

This method of relative strength trading may not immediately appear obvious, but a deeper exploration of the "natural" spreads between the indices could be considered one more tool in a portfolio's toolkit for either risk management purposes or directional trading.

While we are on the discussion of emerging markets, the CBOE Emerging Markets ETF Volatility Index Security Futures (VXEMSM) traded on the CFE allows an investor to employ this contract for possible protection from emerging market volatility risk or as a directional trade. The VIX calculation methodology is applied to CBOE listed options on the iShares MSCI Emerging Markets ETF to derive a measure of implied volatility.

Returning to the idea of relative strength between the volatility indices, Chart 2 below demonstrates the correlation between the Emerging Market Volatility spot market (VXEEM) and the S&P 500 VIX futures spot market, thus allowing for possible spreading opportunities between these contracts. Over the past year, there appears to be a tendency of a correlation between the two markets, thus seeking opportunities when the spread becomes too large or too narrow.

An investor may also find volatility indices for commodities at the CFE. In March of 2011 the CFE added the CBOE Gold ETF Volatility Index (GVSM) Security Futures contract and the CBOE Crude Oil ETF Volatility (OVSM) Index Security Futures in March 2012.

The GV is derived from VIX methodology applied to options of the SPDR Gold Trust (GLD). The OV futures contract is derived from the VIX methodology applied to options of the United States Oil Fund (USO).

As gold and oil are considered indicators of inflation, growth or contraction of an economy or their pricing relationship to the U.S. dollar, the gold and oil ETF volatility index security futures contracts may add value as implied indicators of their underlying markets for risk protection, directional trading or as spreads against each other and against equity markets.

Chart 3 below demonstrates the volatility of the gold, oil and S&P 500 spot markets over the past 19 years. Oil has maintained a higher baseline of volatility. When oil is near the bottom of the baseline in the low 30s to low 20s it offers a potential spreading or directional opportunity for volatility futures. That same baseline is often considered a mid to upper level range for the S&P 500 and gold as noted in Chart 3 and could be advantageous in determining a spreading or directional opportunity.

As of 2011, Brazil was the 11th largest producer of oil and could be in the top five of oil producing nations by 2020.iv This may result in Brazil changing from being an oil importer to an oil exporter impacting their economy. As Brazil increases its oil production in the future, this may allow for a stronger interaction between the oil market and the Brazilian economy, thus employing an OV/VXEW spreading strategy. This is a trading strategy to keep a lookout for in the future.

Chart 4 below is an example of the recent volatility of the Brazilian and oil ETFs.

In summary, investors have choices of strategies to utilize the growing product list of CFE volatility indices. These include utilizing the volatility indices for possible tail risk reduction, directional trading or relative strength spreading among the volatility product indices.

i "March is Record Setting Month at CBOE Futures Exchange", April 2, 2012. Press Release.

Mark Shore is also an Adjunct Professor at DePaul University's Kellstadt Graduate School of Business in Chicago where he teaches a managed futures/global macro course and an Adjunct at the New York Institute of Finance. Mark is a contributing writer to Reuters HedgeWorld

Mark is a frequent speaker at alternative investment events including events hosted by Goldman Sachs, Merrill Lynch, Morgan Stanley, Institutional Investor, International Association of Financial Engineers (IAFE), the University of Chicago, DePaul University, Tulane University, the Illinois Economics Association, the Illinois Institute of Technology, and HedgeWorld.

Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Always review a complete CTA disclosure document before investing in any Managed Futures program. Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.

VIX White Paper

The CBOE Volatility Index (VIX ) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility.

CBOE Volatility Indexes

CBOE's volatility indexes are key measures of market expectations of near-term volatility conveyed by stock index option prices. The indexes measure the market's expectation of 30-day volatility implicit in the prices of near-term index options. The indexes are quoted in percentage points, just like the standard deviation of a rate of return, e.g. 19.36. CBOE disseminates the index values continuously during trading hours. The indexes are leading barometers of investor sentiment and market volatility relating to key stock indexes.

Unique Features of Futures and Options on the CBOE's Volatility Indexes

Futures and options on the CBOE's volatility indexes have several features that distinguish them from most equity and index options. Here are links to unique features of VIX options?

CONTACT

About Larry McMillan and McMillan Analysis Corporation
Lawrence McMillan is the recipient of the Sullivan Award for 2011, awarded by the Options Industry Council in recognition of his contributions to the Options Industry. Professional trader Lawrence G. McMillan is perhaps best known as the author of Options As a Strategic Investment, the best-selling work on stock and index options strategies, which has sold over 200,000 copies. An active trader of his own account, he also manages option-oriented accounts for certain individuals and in addition, he is the Portfolio Manager of The Hardel Volatility Arbitrage Fund (a hedge fund). In a research capacity, he edits and contributes to his firm's publications: Daily Volume Alerts, The Option Strategist and The Daily Strategist—derivative products newsletters covering equity, index, and futures options. Finally, he speaks on option strategies at many seminars and colloquia in the United States, Canada, and Europe. He is quoted in publications such as The Wall Street Journal, Barron's, Technical Analysis of Stocks and Commodities, Data Broadcasting's Exchange magazine, Futures Magazine, theStreet.com, and Active Trader Magazine. In these capacities, he is the President of McMillan Analysis Corporation, which he founded in 1991. Prior to founding his own firm, Mr. McMillan was a proprietary trader at two major brokerage firms—primarily Thomson McKinnon Securities, where he ran the Equity Arbitrage Department for nine years.

About Michael McCartyMichael McCarty is the founding member and chief strategist of Differential Research. An independent provider of derivative research for institutional investors. Differential Research was founded to capitalize on the growing importance of risk and volatility analysis in the investment process. Mr. McCarty is a frequent guest on BloombergTV, Fox Business News and CNBC, in addition to being quoted regularly by the financial press. Mr. McCarty also speaks frequently on the topics of risk and volatility at investment industry conferences.

Michael McCarty was formerly the Chief Strategist at Meridian Equity Partners, an independent broker dealer. As director of the firm's Option Market Operations, Mr. McCarty published two widely-read notes per day, targeting on the US marketplace and uncovering Noteworthy Option Activity.

Born in the Republic of Panama and raised in Central Florida, Mr. McCarty's fascination with the financial markets came early on, first studying finance and history at Emory University, then obtaining a Masters Degree in Finance from New York City's Baruch College – Zicklin School of Business. His vast knowledge and deep understanding of the equity and derivative markets, the result of a twenty-five year Wall Street career as sales-trader, analyst and market strategist has allowed him to accumulate a significant following of the most respected and accomplished investors worldwide.

About Mark ShoreMark Shore has more than 20 years of investment, research and futures experience. In 2008 he founded Shore Capital Management LLC where he consults in alternative investments regarding due diligence, research, educational workshops and business development. He is a frequent speaker at alternative investment events.
He has published several papers on alternative investments and asset allocation. His research is found at www.shorecapmgmt.com.

Mr. Shore is an Adjunct Professor at DePaul University's Kellstadt Graduate School of Business where he teaches a graduate level managed futures/ global macro course. He is also an Adjunct Instructor at the New York Institute of Finance and a Contributing Writer for Reuters HedgeWorld and the CBOE Futures Exchange.
Prior to founding Shore Capital, Mr. Shore was Head of Risk for Octane Research Inc ($1.1 billion AUM) in NYC from 2007 to 2008, where he was responsible for quantitative risk management analysis and due diligence of Fund of Funds. He chaired the Risk Management Committee and was a voting member of the Investment Committee.

Prior to joining Octane, he was at VK Capital Inc from 1997 to 2006, a wholly owned Commodity Trading Advisor ($250 million AUM) of Morgan Stanley. As Chief Operating Officer of VK Capital, Mr. Shore provided research and risk management expertise on portfolio issues, product development and business strategy.
Mr. Shore graduated from DePaul University with a degree in Finance. He received his MBA from the University of Chicago.

The information in this newsletter is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current. Many of the matters discussed are subject to detailed rules, regulations, and statutory provisions that should be referred to for additional detail and are subject to changes that may not be reflected in this newsletter. The strategy discussions contained in this newsletter are designed to assist individuals in learning how volatility and variance futures as well as other volatility-based derivatives work and understanding various volatility derivatives strategies. The strategies discussed are for educational and illustrative purposes only and should be not be construed as a recommendation to buy or sell a security or futures contract or to provide investment advice. Additionally, commissions and other transaction costs have not been included in the example strategies and will impact the outcome of security and futures transactions and must be considered prior to entering into any transactions. Investors considering volatility-based derivatives should consult a professional tax advisor as to how taxes affect the outcome of contemplated transactions in volatility-based derivatives. The charts and/or graphs contained herein are intended for reference purposes only. Past performance is not indicative of future results.

The views of third party contributors to this newsletter are their own and do not necessarily represent the views of CFE or its affiliates. Third party contributors are not affiliated with CFE. This newsletter should not be construed as an endorsement or an indication by CFE of the value of any third party product or service described in this newsletter.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606.

The methodologies of the CBOE Volatility Index (VIX) and the CBOE DJIA Volatility Index (VXD) are owned by CBOE and may be covered by one or more patents or pending patent applications.